Free Market Economics in a Nutshell
A central aspect of understanding issues in business ethics in the United States as well as many other countries is to have a solid grasp of the basic principles of free market economics. While this is not meant to be a comprehensive explanation of these principles it is a good reference point and place to begin your study.
In a free market individuals own the means of production and use these to produce goods and services which are sold to consumers at a price. The free market can be seen as the collection of individual decisions as they relate to these activities of producing and purchasing.
As defined by Thomas Sowell, economics is the study of the allocation of scarce resources which have alternative uses. Given this, a central necessity in any economy is the ability of individual producers and consumers to calculate how much of any given good or service to produce and consume. In a free market, this information is transmitted via prices. High prices indicates certain relationship between the supply of producers relative to the demand of consumers such that there are more consumers demanding the product than producers are currently able to supply. Low prices also indicate a certain relationship such that there are more producers making the product than there are willing consumers. In each case the information that prices communicate is about the ration of supply and demand. While it's tempting in some situations to wish that prices could be controlled (and there are no shortage of politicians willing to suggest laws to do so!) this will not change the underlying relationship that the prices are communicating. If anything it will simply distort the relationship causing more problems.
But, aren't prices just arbitrarily set to allow produces to make as much money as possible?
No, prices are the end result of negotiations among producers and consumers and allow each to determine the relative supply and demand of any given product. In a free market prices convey useful information telling producers how much of a given product to make. All prices are flexible and change over time when the ratio of supply and demand changes.
Don't some producers engage in price gouging, especially during crises like hurricanes and floods?
What appears to be price gouging is in fact a useful example of the practical value of pricing as a means of communicating information. When prices go up to indicate a shortage this has two beneficial effects, especially during disasters. First, it signals other producers to increase production in an effort to meet unmet demand. Second, it signals consumers that there are shortages and encourages those who do not need the resources as much to refrain from purchasing until supply and demand are more in line with ordinary levels.
It is important to remember that forbidding prices to go up in such times (as some lawmakers attempt to do) does not change the relationship between supply and demand that exists except to distort it usually making demand greater and supply all the more scarce.
But, during normal times can't a producer just charge a higher price just to increase their profit?
This is a common question which conceals a fallacy. The assumption is that no other producers will detect the artificial gap between the cost of production and final price. If I am a producer who wants to increase my profit by raising my price higher above my costs of production, can't another producer simply come in, undercut my price, and make a profit? This is what occurs in a free market economy and works to keep prices down. In order to increase profits producers seek to lower costs not raise prices.
OK, but take the example of gas prices. When they go up my gas station instantly raises the price to reflect the new higher price when the gas they already have was purchased at a lower price. What about that?
Let's look at an example (offered by economist Walter Williams). Suppose I have a supply of coffee that I keep on hand and from time to time I sell you some of my coffee when you can't get to the store to buy it yourself. I usually buy my coffee for $6.00 a pound and I have 10 pounds on hand to sell. I usually sell it to you for $6.00 a pound just to cover my cost. Now, one day the price of coffee goes up to $8.00 a pound. When I offer to sell it to you for this $8.00 a pound you protest that the coffee I have on hand wasn't purchased at $8.00 a pound so you should not have to pay this price. Now, what's the flaw here? Well, don't I have to replace the coffee I sell to you? And when I do so, I will have to pay the new $8.00 a pound price. So to cover my cost of replacement I need to sell you the coffee for $8.00 a pound. This is exactly what the gas station is doing when it immediately raises its prices.
For Further Reading:
Thomas Sowell: Basic Economics
Thomas Sowell: Applied Economics
Robert Frank: The Economic Naturalist
Mark Skousen: The Power of Economic Thinking
In a free market individuals own the means of production and use these to produce goods and services which are sold to consumers at a price. The free market can be seen as the collection of individual decisions as they relate to these activities of producing and purchasing.
As defined by Thomas Sowell, economics is the study of the allocation of scarce resources which have alternative uses. Given this, a central necessity in any economy is the ability of individual producers and consumers to calculate how much of any given good or service to produce and consume. In a free market, this information is transmitted via prices. High prices indicates certain relationship between the supply of producers relative to the demand of consumers such that there are more consumers demanding the product than producers are currently able to supply. Low prices also indicate a certain relationship such that there are more producers making the product than there are willing consumers. In each case the information that prices communicate is about the ration of supply and demand. While it's tempting in some situations to wish that prices could be controlled (and there are no shortage of politicians willing to suggest laws to do so!) this will not change the underlying relationship that the prices are communicating. If anything it will simply distort the relationship causing more problems.
But, aren't prices just arbitrarily set to allow produces to make as much money as possible?
No, prices are the end result of negotiations among producers and consumers and allow each to determine the relative supply and demand of any given product. In a free market prices convey useful information telling producers how much of a given product to make. All prices are flexible and change over time when the ratio of supply and demand changes.
Don't some producers engage in price gouging, especially during crises like hurricanes and floods?
What appears to be price gouging is in fact a useful example of the practical value of pricing as a means of communicating information. When prices go up to indicate a shortage this has two beneficial effects, especially during disasters. First, it signals other producers to increase production in an effort to meet unmet demand. Second, it signals consumers that there are shortages and encourages those who do not need the resources as much to refrain from purchasing until supply and demand are more in line with ordinary levels.
It is important to remember that forbidding prices to go up in such times (as some lawmakers attempt to do) does not change the relationship between supply and demand that exists except to distort it usually making demand greater and supply all the more scarce.
But, during normal times can't a producer just charge a higher price just to increase their profit?
This is a common question which conceals a fallacy. The assumption is that no other producers will detect the artificial gap between the cost of production and final price. If I am a producer who wants to increase my profit by raising my price higher above my costs of production, can't another producer simply come in, undercut my price, and make a profit? This is what occurs in a free market economy and works to keep prices down. In order to increase profits producers seek to lower costs not raise prices.
OK, but take the example of gas prices. When they go up my gas station instantly raises the price to reflect the new higher price when the gas they already have was purchased at a lower price. What about that?
Let's look at an example (offered by economist Walter Williams). Suppose I have a supply of coffee that I keep on hand and from time to time I sell you some of my coffee when you can't get to the store to buy it yourself. I usually buy my coffee for $6.00 a pound and I have 10 pounds on hand to sell. I usually sell it to you for $6.00 a pound just to cover my cost. Now, one day the price of coffee goes up to $8.00 a pound. When I offer to sell it to you for this $8.00 a pound you protest that the coffee I have on hand wasn't purchased at $8.00 a pound so you should not have to pay this price. Now, what's the flaw here? Well, don't I have to replace the coffee I sell to you? And when I do so, I will have to pay the new $8.00 a pound price. So to cover my cost of replacement I need to sell you the coffee for $8.00 a pound. This is exactly what the gas station is doing when it immediately raises its prices.
For Further Reading:
Thomas Sowell: Basic Economics
Thomas Sowell: Applied Economics
Robert Frank: The Economic Naturalist
Mark Skousen: The Power of Economic Thinking